Sunday, March 29, 2009

Over the past two months, it has become painfully obvious that everyone who has anything remotely to do with finance has become an expert on the bond-CDS basis trade. While this is absolutely fine, the problem is that understanding the fundamentals in basis is essentially pointless from the perspective of actually trading it, as lately (and for the foreseeable future) fundamentals will matter exactly diddly squat, now that technicals have become (and will be) the dominant trading factor. Zero Hedge would also claim that financial backgrounds bear no significance in this matter, and only individuals who deal with mass hysteria, crowd psychology, cognitive science and other social phenomena could shed any further light on this issue (for a good start, we recommend the DE Shaw basis overview piece posted a few weeks ago, despite their alleged trade axe, as sellers of basis vol. Probably one of the most interesting points in the DE Shaw report is the observation on the significant positive basis in Berkshire, since banks bought BRKCDSasymmetrically, as they would not receive daily variation margin posts for in the money derivative positions due to BRK's AAA rating and thus had to hedge directly via CDS... same thing for GE - it is interesting if now that both have been downgraded, and variation margin is not an issue, their CDS is due for an even larger drop purely from basis trade unwinds).

In pursuit of "relatively risk free" alpha, many hedge funds have established index basis positions over the past several weeks, following the overall equity market euphoria, anticipating an improvement in hedge fund liquidity options as a derivative of a "loosening credit market", and thus, a significant convergence of the cash and synthetic legs. I would caution strongly against a long-term basis position at this point, as this is yet another example of crowded trade with theoretically unlimited downside risk, even more so considering that the 5 year investment horizon presents numerous opportunities for six sigma and risk flaring events to emerge. And if there is anything Zero Hedge is convinced about, is that many of the latter-type phenomena will imminently reappear. As DE Shaw calls it eloquently, the IG basis is selling a 5 year put option on market liquidity: it takes a unique (and very cash flush) optimist to believe that the events of Q4 and early 2009 will not repeat themselves prior to 2014. Lastly, the basis has moved out of alpha land, and is now essentially a (leveraged) play on beta. There are easier, cheaper and less Rogaine-purchase inducing ways to play beta.

So is there nothing that can be done with basis?

On the contrary. Zero Hedge believes that one of the best opportunities in the market currently is exactly the cash synthetic divergence, but not in investment grade names, and definitely not with a five year horizon. Instead, I believe the basis in very distressed, HY names will soon generate some good returns. Playing the HY basis is different than the IG basis (where an account buys IG11 or 12 and buys underlying bonds). The problem with IG basis is that it is at its core it is a bullish trade: a return to normality (or the widespread perception thereof) from a liquidity standpoint is critical for convergence to occur. Anything inbetween is merely daily volatility and the only beneficiaries are those who sell the IG basis vol without taking any principal positions.

The HY basis, however, makes no stipulations about the macro improvement, and in fact is reinforced by it. The trade is predicated on a collapse of the basis in the context of an event of default: in this sense it is a bearish trade, with a much nearer investment (and event) horizon. The trade is, of course, not risk free, as many of the underlying reinforcing social dynamics that govern IG recur in HY basis as well, and a liquidity flaring event will likely wreck havoc in both domains, but inevitably with lesser repercussions in HY... mainly because the negative implications of liquidity deterioration at the macro level, will flow through to the micro realm, and all else equal, will likely accelerate defaults and thus payouts.

In the table below, I have presented several interesting opportunities where it is possible to benefit from a negative HY basis. The list (which is by no means exhaustive) focuses on the names that are perceived to be most at risk from bankruptcy (or have recently succumbed to it, as per Charter). As an event of default will result in a forced cash-CDS convergence, and taking advantage of the cheapest to deliver option, buying protection in a specific name, together with a comparable bond purchase, only to deliver the underlying bond to the CDScounterparty as part of the ensuing ISDA physical settlement auction, means that negative bases in HY are likely much less risky, much more self-reinforcing from a macro-mirco event perspective and likely to be consummated much sooner due to the definitive event horizon.

Buying the indicative basket of names from the above list would result in a roughly 6% return, as the 15 names presented experience "events of default." (Incidentally, Zero Hedge makes no claim to the viability of these 15 companies: for all we know, all 15 of them may trade at par tomorrow). As the list was based on a cursory assessment, it is possible that many more neg basis opps exist in uber-distressed land.

In summary, while the IG basis (either with or without an IG index as a constituent) is a trade, whose convergence is dependent on a very questionable return to "liquidity normalcy", the HY basis approach, is the bearish side of the coin, where highest alpha is achieved (with beta mitigation) as the economic deterioration becomes more pervasive, as more fallen angels appear, and as more highly levered companies meet their inevitable "EOD" fate.
Sphere: Related Content

Hey ZH - agree with your view on IG basis (which becomes an even more stressed short-term trade given single-name underperformance relative to indices) BUT one of the bigger drivers in the HY basis which makes it a little more risky is the evnt-risk arb - distressed exchanges are increasingly de rigeur and we believe a significant amount of the distressed basis is CDS being marked up to cover for this difference in default (bond is 'swapped' into something worth less and CDS does NOT get triggered somehow).

No so fast ! There is an interest component in the arbitrage. Bonds tend to default just before the coupon payment. "Naive" CDS pricing does not always capture this. Also, distressed names trade mostly on an upfront basis + 5% current, so the "bond equivalent" rate relies on a default model that must be fed with assumptions, that could be wrong !.Even if CDSs are branded as "vanilla" products, they are complex derivatives and "understanding the fundamentals in basis" is indeed essential.